BUITER: The Unintended Consequences Of A European Banking Union

Implicit in Mario Draghi's statement today was the need for the various Eurozone governments to do more to stem the crisis.

One of their potential courses of action, agreed to in principal during a June Eurozone summit, is a common banking union.

Citi's Chief Economist Willem Buiter is out with a note dissecting such a plan.

"Banking Union for the euro area is essential for the survival of EMU, but may have unintended consequences in our view," he writes.

He see three large unintended consequences:

Increased likelihood of strategic sovereign default:

A strategic default could occur if a country determined that the costs of default (reputational, exclusion from markets) are less than the benefits (debt reduction). A banking union could decrease one of the major costs of default, the possibility of a collapse in a domestic banking system, by decreasing bank exposure to domestic debt and permitting the ESM to independently recapitalize banks.

Mutualization of financial repression:

Financial repression refers to pressure put on domestic banks by struggling sovereigns to buy up national debt to keep bond yields low. Should a banking union be formed and national banking regulators lose their power, the need to keep periphery yields low would remain. Buiter anticipates that that financial repression would spread throughout Europe in that case, and cause significant political problems.

An increased likelihood of bailing in unsecured bank creditors:

In the event of bank recapitalization or resolution, private unsecured creditors would be more likely to see haircuts in the value of their equity and debt holdings. Buiter sees this as likely due to German political pressure, a relaxation of the ECB's position on the matter, and the fact that there may not be enough financial resources available to recapitalize banks without such a bail in.